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Well, I survived another brutal tax season, and unfortunately I still have a ton of extended returns to get out in the next week, but the last thing I need is ODR wasting my time with incorrect notices to clients that force me to double and triple check OR PTE calculations. I had to post this really quick in case there is anyone else out there with this scenario:

Filed an OR 40P Part-Year Resident return for 2015?

Was Schedule OR-PTE-PY included?

If both apply to you and you have received a letter from ODR with a proposed refund adjustment, then there is a good chance that their adjustment is incorrect – especially if they are proposing a lower tax amount that is equal to the tax on the OR-PTE-PY form, Section B, line 19a multiplied by your Oregon percentage from Form 40P, line 35.

The OR-PTE-PY is new this year, and the worksheet in Section B can be very confusing the first time through, but the most important thing is the the worksheet already multiplies the tax amounts by the Oregon percentage and the Oregon non-passive percentage, so by the time you get to line 19a, it is already pro-rated. For this very reason, ODR lists specific instructions below line 19a “Don’t multiply the tax by the Oregon percentage as instructed on line 48 of the Form 40P.” . However, on the notice I received, they have done just that in their proposed tax number – they have multiplied the amount on line 19a from OR-PTE-PY Section B by the Oregon percentage, which is incorrect. We had even clearly marked box 47c on Form 40P as they requested, but they still made the error.

The thing that frustrated me is that the return was transmitted on 4/14/16 and they had a letter sent out on 4/22/16, which means a machine is likely kicking these out without any manual review and this could result in a large number of erroneous tax refunds. This is a waste of everyone’s time and money, and coupled with the disastrous late release of OTTER 2016, I am starting to think Oregon needs to following Intel’s lead and clean house at ODR and OED.

One of the highlights of my summer was going to the MLS All Star Game and getting to see FC Bayern Munich and many of the German World Cup winners. I enjoyed booing Clint Dempsey and other Seattle Sounders, witnessed “Pepgate”, and don’t forget the amazing assist by Deigo Valeri.

Much like the way FC Bayern Munich has dominated German and European football over the last few years, QuickBooks has long been the top accounting solution for small businesses. It is easy to learn, flexible, and it provides all the features needed for a complete accounting system that works for both the small business owner and their tax preparer. It is by no means a perfect small business accounting solution, as I have a lengthy list of suggestions & complaints for Intuit, but it is the best solution you are going to find for the price.

In recent years, some low-cost, online accounting solutions have emerged to challenge QuickBooks for the sole proprietorship market by offering more simplistic accounting and integration with other online services like Ebay, Etsy, and PayPal. While I am all for simplicity and keeping accounting work efficient, I am strongly against the use of some of these services, as many of them lack basic reporting features that should be part of even the most simplistic accounting system. To help you avoid these inferior accounting solutions, below are the minimum requirements you should look for before committing to a specific solution.

Balance Sheet Report

If an accounting solution only provides a profit and loss report, you are missing out on crucial accounting information and an important tool that enables you to verify that your accounting records are accurate and complete. In fact, if a balance sheet report is not provided as a standard report, it should be an outright deal-breaker and “go-time” to find a different solution.

A balance sheet report provides the balances of your assets, liabilities and equity as of a specific date. This would include all your bank and credit card accounts, loans, fixed assets and accumulated depreciation accounts, payroll liabilities, and most importantly – your accumulated draws taken from the business. Even if you have a small sole proprietorship, you likely have a number of these accounts, as most business owners use credit cards and PayPal, but even if you only have one bank account and no debt, you still need to be able to generate a balance sheet so that you can see how much net profit you have withdrawn from the business. After all, one of the most difficult issues for a small business owner is determining how much cash needs to be left in the company and how much can be safely withdrawn.

In addition to providing you with account balances and your remaining equity in the company, the balance sheet report is also an important tool, and the document that most CPAs and tax preparers use to confirm that your accounting records are correct. If you have a quality tax preparer, they will take a balance sheet approach when doing the accounting work for your tax return, which means they will reconcile each balance sheet account to third party and other verifiable documents and reclassify any differences to profit and loss accounts. Once all the accounts on the balance sheet are reconciled and tied out, you can be confident the profit and loss is correct. Without the balance sheet, you would not know if changes were made to the prior year, if transactions were missing, or if there were duplications and other errors. Most CPAs and tax preparers require a balance sheet to prepare a tax return – even for sole proprietorships and small LLCS – so do not use a service that does not offer a balance sheet report.

Bank & Credit Card Account Reconciliation

I love technology and the fact that you can save hours of input work by importing transactions from banks right into accounting solutions. Even better, most accounting solutions remember expenses categories for vendors, so the input side of bookkeeping work is becoming easier. However, that doesn’t mean you can neglect basic accounting procedures like reconciling your bank and credit card accounts. It is still the best way to verify that the data in your accounting system matches the bank and that there are no duplications, stale checks, or other input and/or import errors, and your accounting solution should make the process a quick and painless.

Reconciling is the process of matching the individual transactions input and/or imported into the accounting system to a bank statement until the cleared balance in the accounting system matches the ending balance per the bank statement. The reconciliation report is important verification that your accounting records are complete and not missing any transactions, and most CPAs and tax preparers will want a copy when preparing your return, as the IRS’s most effective audit technique is their bank account analysis. Reconciliations also help identify old outstanding checks and duplications and errors that need to be voided. Without reconciliations, there is no guarantee that your accounting records are correct.

The overconfidence in imported data in an accounting system often leads to duplication errors and grossly misstated financial statements, which makes the reconciliation process even more important. Importing works great for straightforward expense transactions, but bank transfers and balance sheet transactions often create problems. Much care needs to be taken when you are reviewing and categorizing the imported transactions, and the accounting solution is not always correct in its categorization. Plus, always keep in mind that only cleared transactions are downloaded and imported – you still have to manually input any transactions that have not cleared the bank, as expenses are deductible when the check is written or charge is made, not when it clears the bank, so do not miss out on tax deductions by taking bookkeeping shortcuts. Take the time each month to reconcile all your bank and credit card accounts and review your outstanding transactions, and you will dramatically improve your accounting records and maximize your tax deductions.

All quality accounting solutions have a reconciliation feature where you can check off each deposit and check/charge as you match them to the bank statement. For example, QuickBooks, has a very easy to understand reconciliation feature that hides all transactions after the statement date, tracks the difference between the cleared balance and the bank statement balance, and allows you to click through to transactions if corrections need to be made. There are accounting solutions out there that do not offer such a feature in the name of “simplicity”, or they have a very limited reconciliation feature – please avoid these solutions at all cost. Reconciliation of bank and credit card accounts is a basic accounting function, and failure to reconcile your accounts each month results in accounting records that are simplistically inaccurate.

Statement of Cash Flows

Like the balance sheet, a statement of cash flows is an essential report that that is a minimum requirement for an accounting system. The report begins where the profit and loss report ends and shows you the inflows and outflows of cash unrelated to income and expenses, which often include loan payments, owner draws, equipment acquisitions, and loan proceeds. Even with a simple business, the statement of cash flows is just as important as the profit and loss report, so make sure an accounting solution offers a cash flow report before deciding on it.

Drill-Down Reporting and Transaction Attachments

The ability click on a transaction and quickly view the transaction is crucial for an accounting solution. As a decision maker reviewing financial statements, you are often looking for variances of concern, and you need to be able to quickly find the reasons for the differences without too many steps. You should also be able to go to the source transaction and related transactions quickly, and have the option to attach pdfs of receipts to the transactions. Make sure you use a sample company in an accounting solution before deciding on purchasing it, as minor issues with drill-down capability can cause major aggravation and waste time you could spend growing your business.

Reporting for All Entity Types

An accounting solution should have flexibility for future growth and not be limited to a specific business entity type like a sole proprietorship or simple LLC. Granted, a simplistic accounting solution may sound great for your small Schedule C business, but what about a few years later when you are looking to elect to be taxed as an S corporation? Are you going to wish you had just gone with QuickBooks so you do not have to deal with the hassle of a software migration? Businesses can grow quickly, and you need an accounting solution that is flexible enough to handle any changes. I spend much of my time assisting business owners with changes to their business structure – everything from adding new owners to converting to an LLC or S Corporation for tax savings purposes, and these changes are complex enough without having to worry about accounting software, so make sure you think long range before deciding on an accounting solution.

There you have it – my minimum requirements for an accounting solution. I am sure there are many more, so feel free to share. Also, if you have any bad experiences with particular solutions, please share with my readers. My parting advice (in case you missed my not so subtle hints)– steer clear of accounting solutions offered by web hosting companies. They are outright horrible.

I have written two prior posts on this issue, and there has been a lot of discussion and important contributions from readers, so I wanted to compile all the information in one post.

The Basics:

Partnerships and entities taxed as partnerships (LLC, LLP, etc) are required to file annual returns by 4/15. A five month extension is available, making the final deadline 9/15. Strict penalties are assessed by the IRS if you file late.

The penalty is currently $195 “per partner, per month” that the return is late. This can add up really fast, and average late filing penalties result in several thousand dollars of non-deductible fees that the IRS is making more and more difficult to get removed.

It does not matter if your business taxed as a partnership did not make any money or never really took off – if you registered for an EIN# or have filed previous returns, you need to follow through and returns annually. The IRS is not going to listen to they type of excuses.

Abatement Option #1 – Rev Proc 84-35

If the partners or LLC/LLP members filed their personal returns timely (4/15 or extended and filed by 10/15), then you may have a get out jail card that has been available for over a decade now and provides automatic penalty abatement.

Here is the complete list of factors:

The partnership has to be a domestic partnership,

have 10 or fewer partners (husband and wife and their estate are treated as one partner),

all partners have to be natural persons (other than a nonresident alien) or an estate of a deceased partner,

each partner’s share of each partnership item has to be the same as their share of every other item,

all partners need to have timely filed their income tax returns, and

all the partners need to have fully reported their share of the income, deductions, and credits of the partnership on their timely filed income tax returns.

Now, it seems the IRS has grown tired of Rev Proc 84-35 abatement requests, as they have been trying to shift the discussion of penalty abatement to “reasonable cause”. Do not let them do this! Rev Proc 84-35 is available if you meet the criteria. Even if you have claimed it several years, do not let them try to claim that they cannot abate the penalty or get you side-tracked with a reasonable cause argument – stick to citing Rev Proc 84-35 until you get your abatement.

Important! This does not work for S corporations and LLCs taxed as S corporations. A similar Rev Proc for automatic abatement was unfortunately never created for them. For more information, read my post on S corp late filing abatement.

Abatement Option #2 – The TEFRA Complication

A few years ago, the IRS was looking to raise revenue (they have lavish parties in Disneyland to pay for) and employed a new tactic to reduce partnership late filing penalty abatements. They found that if a partnership had filed a TEFRA election, that they would not be eligible to use Rev Proc 84-35 to request abatement. Suddenly, many CPAs who submitted standard Rev Proc 84-35 abatement requests were receiving denials with the IRS claiming the client had filed a TEFRA election.

For all the background on this complication, read my penalty update blog post, but the short story is that the IRS would claim the election was filed clear back in 2002 or earlier, and the client had to dig up a copy of the tax return to prove the election was not made or put together a letter – signed by all partners/members – stating that a TEFRA election had never been filed. Even then, it often took many letters back and forth or messages on the now defunct IRS eServices resolution service.

I have personally dealt with this issue several times and was able to get abatement in each case; however, I have not had to deal with it in over a year. Fortunately, some PDXCPA blog readers have had some more current experience, and there was really good information shared in the comments section of the prior posts. Specifically, Melissa F. Hill, CPA provided a sample abatement letter and backup documentation that became a popular request on this blog. The documents she has been emailing to readers are available below:

I like Melissa’s sample letter, as that is how you should frame you argument – cite Rev Proc 84-35 and then maintain that a TEFRA election was never filed and request they provide their proof of the election. A letter signed by all partners maintaining that the election has never been filed helps as well.

Sometimes they will respond with a tax year that they claim the TEFRA election was made in, but then they will claim that it will take them awhile to get a copy from archives. If you are organized and have a copy of the return, send them a copy and continue to maintain your assertion that the election was not filed and that Rev Proc 84-35 should apply. You may have to be persistent and put up a strong fight for abatement, but keep trying and do not let them bring up reasonable cause.

I wrote about about the reporting of health insurance for more than 2% shareholders last November and provided an excerpt from my book on the subject, but for 2013, this issue is even more crucial because of several tax changes. As a more than 2% S Corporation shareholder, your total health and dental insurance premiums for the year need to reimbursed (if not paid directly) by the corporation and included on your W-2. If this is not done correctly, you are technically not allowed to claim the self-employed health insurance deduction on your individual tax return, and instead you have to claim the deduction on Schedule A. This treatment has never been desirable because of limitations on Schedule A, but for 2013 the limitations have been increased. First, the medical expenses floor has increased to 10% (up from 7.5%), which means you only get a deduction for the amount of expenses that exceed 10% of your adjusted gross income. Secondly, the itemized deduction phase-out (Pease limitation) is back for 2013 for higher income taxpayers, so even if your medical expenses exceed the 10% floor, you could encounter further limitation. Overall, the difference between a self-employed health insurance deduction and a very limited deduction on Schedule A can translate to thousands of dollars in taxes for a shareholder, and all because of a minor reporting error.

Here is what you need to do before year-end:

Calculate total health and dental insurance premiums for the year for each >2% shareholder (including premiums that will be paid before year-end).

Make sure the premiums have been paid or reimbursed by the S Corporation.

If amounts were deducted from a >2% shareholder’s wages for a portion of their health or dental insurance, contact your CPA or tax preparer, as adjustments will need to be made. These deductions should not have been made, so immediate modifications will need to be made to your payroll processing.

Contact your payroll processor to have the total 2013 health/dental insurance amount added to your W-2 BEFORE the last pay date in the calendar year. Also, have them coordinate with your CPA or tax preparer to make sure it is reported correctly.

I am by no means a “precog”, nor can always predict when minority ownership in a small business will result in disaster, but my 14 years of experience with small business clients has taught me a great deal about what not to do when structuring a business and offering ownership to employees.

If you are currently a minority owner (<50% interest) in an LLC taxed as a partnership or a traditional partnership, or you are being offered such ownership, you may want to consider running away from the ownership if certain warning signs are present. Also, I highly recommend having your tax professional and/or lawyer look everything over before you sign anything. Business ownership is a lot like marriage, so know what you are getting into.

Minority Ownership Warning Signs in LLCs and Partnerships

The entity does not increase guaranteed payments by 5% to cover self-employment tax

When an employee becomes a partner or LLC member, their tax burden increases substantially because of the self-employment tax. Generally, an employee pays social security and Medicare tax of 7.65% on gross wages, and the employer pays another 7.65%. However, an active partner or LLC member is considered self-employed and has to pay both the employee and employer portions of social security and Medicare tax, which total 15.3%. Fortunately, the IRS allows a deduction for one half of the self-employment taxes paid (just like the deduction available to employers), which results in an approximate net rate of 12%. This means that a employee who becomes a partner or LLC member will incur a tax increase of approximately 5%.

Most companies do the right thing and give an employee transitioning to ownership enough additional income to cover this 5% tax increase. The most effective means of doing this is to provide the additional income to the new partner or LLC member in the form of an increase to their regular guaranteed payment. Employees are accustomed to predictable cash flow and regular tax withholdings, so the transition to making quarterly estimated tax payments at a higher tax rate can be difficult. Additional income that is guaranteed and paid on a regular basis is going to ease that transition and insure that there is a tangible benefit to ownership.

Unfortunately, a surprising number of partnerships and LLCs do not provide additional income to employees transitioning to minority ownership, and often it can result in ownership that is actually a detriment to them as a result of the additional tax. Usually, future profits are promised when selling ownership to the employees, and in some businesses, this works very well when consistent profits easily eclipse the 5% tax burden. However, taxable business profits can be very unpredictable due to current accelerated tax depreciation rules and other complications, and in order to distribute profits during the year when they are helpful to the owners, a business has to keep very accurate accounting records. Owners have to pay estimated tax payments quarterly, so the unpredictability of having to rely on distributions of profits can create a lot of dissension among owners – especially during periods of low profits or losses. The sad irony for these businesses who are unwilling to pay the additional 5% in income to partners/LLC members is that they often make ownership offers to employees for the sole purpose of keeping them at the company, and often the tax burden on the new owners does the exact opposite after several years of seeing no benefit to ownership.

The entity is providing capital interest ownership in exchange for services

Giving ownership to an employee in exchange for services can actually work very well if structured correctly and all parties are properly informed of the tax ramifications. However, ideal situations like this rarely happen in the real world, and usually such an arrangement results in a surprise tax bill for the employee receiving ownership. Avoiding such a disaster requires an understanding of the most common types of interests available in small business organized as LLCs.

Capital Interest – this is the default type of LLC interest, as it is a complete ownership that entitles the holder to a share of profits and losses as well as a share of the proceeds from the sale of the LLC’s assets if the LLC liquidates. A capital interest is most commonly given to employees brought on for succession planning purposes.

Profits Interest – this interest is like the capital interest, except a profit interest holder does not receive liquidating distributions from the LLC. In other words, it is only an interest in future profits of the LLC and there is no initial capital balance for the member. A profits interest is often given to key employees much like stock options are given to employees of corporations. It is often intended as a form of additional compensation and a method to retain key personnel.

If you receive a capital interest in exchange for services, it is treated as current compensation in an amount equal to the fair market value of the capital interest at the grant date. The problem is that most small businesses owners organized as LLCs are not aware of this, and rarely do they tell their CPA about such transactions in advance, so it often becomes an ugly year-end or tax-time surprise for the recipient, as they have taxable income to recognize and no cash to pay the tax with. To make matters worse, most small business owners have no idea what the fair market value of their LLC is, so the transaction becomes very complex can create many problems down the road if not done correctly. As an employee being offered such an interest, I strongly recommend asking the LLC to involve their CPA and/or lawyer so that the compensation is determined ahead of time. This will allow you plan accordingly and look into options like the 754 election that can minimize the tax impact.

If you are granted a profits interest in an LLC, no taxable income is recognized as long as the interest satisfies the Revenue Procedure 93-27 safe harbor rules. Most LLCs that offer a profits interest have already had a CPA and/or lawyer setup it up so that the rules are met, so in most cases it is a good deal for the employee receiving the interest. However, it is important to get some prior financial statements and/or tax returns so that you can know what to expect, as sometimes start-ups give profit interests and then go several years without any recognized profit.

The entity does not have a method of equalizing expenses

Single-owner businesses have it very easy in the area of expenses, as they can spend how they want without having to justify to other owners or worry about trying to keep things equal. In multi-owner businesses, there is a constant problem with equalization, as business partners are usually wired differently when it comes to spending and often have different tastes. One LLC member may be tech savvy with smart phones and tablets and another may still prefer a flip phone and a paper legal pad, so it is crucial for a minority owner that an LLC or partnership have an established method of expense equalization in place.

The most flexible method of expense equalization is to have the operating agreement specifically state that the LLC or partnership will not reimburse partners for certain expenses and that they are required to pay for these expenses. As long as it is properly setup in this way, each partner or member can deduct their unreimbursed partnership expenses on their own 1040 tax return on Schedule E page 2. This allows each partner or member to be as lavish or frugal as they want without having to worry about the expenses of the other owners. Often, meals and entertainment, automobile, travel, and office expenses are treated in this fashion.

The second best method is devising a special allocation where certain expenses are allocated 100% to certain owners against their guaranteed payments. This can be elaborate or just a simple calculation done with the tax return preparation, but either way – LLCs and partnerships are extremely flexible in this area. Just make sure the allocation is decided on well in advance, as it is much more difficult to agree on after expenses have already been paid.

That’s it for LLCs and partnerships. In Part 2, I will concentrate on minority ownership issues in S corporations.

Also known as the Shoestring Startup Guide, the book definitely looks like a great resource for anyone considering starting a new small business. I meet with new business owners all the time, and unfortunately I see a lot of new businesses run into early cash flow problems or even fail, so there is a definite need for practical money-saving advice for small business owners.

If you buy the book in July, you get a free Shoestring Startup Guide workbook that provides checklists that can be used to brainstorm money-saving opportunities for your business. Also, you can enter to win a copy of the book on Goodreads.

If you have an overpayment of over $5,000 on your Oregon tax return, be forewarned – the Oregon Department of Revenue may sit on your refund for up to six months while they “manually review” your return.

In the last year, we have witnessed a sharp increase in the number of clients who had their refund delayed by ODR. The only common factor we can find is that they all had large overpayments. In each case, the return was selected for “manual review”, and after weeks and sometimes months of waiting, ODR asks for something as simple as copies of the W-2s (which they should already have since employers are now required to efile W-2s to Oregon). Even after you supply them with copies of the W-2s, the manual review and refund can often take weeks to process. Even worse, when you call them, they offer very little information into why the manual review was triggered in the first place and cite their “policies” without letting you speak to a manager.

If I had to venture a guess as to the reason for these delays, I would point to the embarrassing $2.1 million dollar refund error that ODR made last year. In fact, soon after that error is when our clients started encountering these manual review delays. Could overreaction be the cause of these delays, or are they simply a fumbling bureaucracy that cannot process refunds in a reasonable period of time?

You can draw your own conclusion, but what I do know is that I am changing my tactics when I have a client with a large Oregon overpayment. From now on, I am applying the entire overpayment to the next year and then the client can just pay less in estimates during the year. That way, ODR can take an entire year manually reviewing the return to their hearts content and it will not delay refunds for my clients.

If your 2012 return has been selected for manual review, I would love to hear from you. There is little advice I can give you other than calling ODR every other day, but the more taxpayers voicing concern about this, the better. This needs to be given proper attention, as ODR is wasting the time and money of honest Oregon taxpayers and small business owners.